Money-Smart Solopreneur. Laura D. Adams

a large enough cash reserve could take years. A smart tip that will help even the most undisciplined saver is to automate it.

      For example, if you have a day job, ask your employer to split your paycheck between your regular checking and your emergency savings account. If you’re already fully self-employed, set up an automatic weekly or monthly transfer from your checking account into your cash reserve account.

      Putting your savings goals on autopilot is a great way to stay on track and avoid the temptation to spend the money. You’ll build security without having to think about it. Even if you can only set aside $50 a month, you’ll be surprised by how quickly your account balance can grow over time.

      Think of your cash reserve as a non-negotiable, mandatory bill. It may take a little juggling with your other expenses, but in time, you won’t even miss the money. Plus, having a plan in place to achieve your goals can help alleviate your money stress and increase your happiness. Once you have this safety net in place, you’ll feel more secure knowing that whatever happens with your business or personal finances, you’re prepared to handle it.

      Cash Reserve Mistakes to Avoid

      A useful cash reserve fund should be large enough to get you through a financial crisis and easily accessible, because you need to move fast in an emergency. But that liquidity can make it tempting to spend on nonemergencies. To keep from cleaning out your cash reserve, avoid these three mistakes:

      1. Not setting emergency savings rules. Create clear guidelines for yourself and your spouse or partner about what qualifies as a real emergency and what doesn’t. Tap your cash reserve only in a true emergency situation. For example, if your car breaks down and you need it to get to your day job or to run your business, repairing it is an emergency. Or if your refrigerator stops working, you need to have it fixed or buy a new one so you can have fresh food. But something that you want but don’t truly need, such as a vacation or a new set of golf clubs, is never an emergency.

      2. Investing your emergency savings. As tempting as it may be to invest your cash reserve, it’s typically a bad idea. Money you invest is always subject to some amount of volatility and risk. In general, investing is suitable only for your long-term financial goals (such as retirement, which we’ll cover in Chapter 18). However, if you’re a good saver and have a cash reserve ratio in the range of 6 to 12, investing the excess portion may make sense. For example, let’s say you need a 10-month reserve and you have the equivalent of 12 months in savings. In that case, investing the excess two-month reserve (instead of keeping it in a savings account) might be a good idea, depending on your work and family situation.

      3. Keeping your emergency savings too handy. Don’t take the opposite approach and tuck your cash under the mattress. While you may want to keep some money at home in a fireproof safe, consider putting most of it in a different bank from your other accounts. Using another local or online institution for your emergency savings creates a small but additional barrier to accessing it. You’ll have to initiate a bank transfer, which could help curb any impulsive spending.

Radically Cut Living Expenses

      In addition to building a cash reserve, another safety net you can create is to radically minimize your living expenses and lifestyle. Maintaining high fixed costs might be sustainable when you have a steady salary or a secure job. But if you plan to become fully self-employed, expect your income to vary. To manage the ups and downs, you’ll need to find ways to be as financially flexible as possible.

      While you’re building your emergency fund, consider lowering your expenses at the same time. If you’re like most people, you can probably stand to cut some or many smaller expenses, such as dinners out and impulse purchases.

      However, I recommend that you focus on reducing your largest expenses first. That’s how you can truly transform your financial life. Housing and vehicles are the typical big-ticket items that suck up most of your income. By reducing or eliminating them, you can free up the most money.

      How can you slash your housing costs? It can be challenging, but it is a wise place to start because it is probably the largest portion of your expenses. Housing costs vary dramatically depending on where you live, but a good rule of thumb is that your basic mortgage or rent payment should be no more than 25 percent of your gross income.

      You can use the housing expense ratio to evaluate how much you spend on your rent or mortgage compared with how much you earn. It’s calculated by dividing your housing expense by your gross income over a set period, such as monthly or annually:

      Housing Ratio = Housing Expense / Gross Income

      For example, say your rent is $1,500 per month, or $18,000 per year. If you earn $80,000 a year, your housing ratio is $18,000 divided by $80,000, which is 0.23 or 23 percent.

      Paying no more than 25 percent of your monthly gross income for your rent or mortgage principal and interest is ideal. If you can keep it under 20 percent, that’s even better.

      Also consider the total housing expense ratio, which includes rent, mortgage principal, interest, property taxes, insurance, and homeowner’s association fees. Keeping this ratio under 30 percent of your gross income is wise.

      If you’re in the market to buy a home, another good rule of thumb is to limit the amount you borrow to three times your gross annual income. For instance, if you make $80,000 per year, don’t take out a mortgage that’s more than $240,000. If you make a 20 percent down payment, that would allow you to buy a home worth $300,000 ($240,000 mortgage plus $60,000 down). Again, shooting for a smaller amount, such as 2.5 times your gross annual income, would give you more financial breathing room.

      If your housing expense is a source of financial stress, take a hard look at downsizing or relocating to a different neighborhood or town. Taking a similar or better job in a less expensive area could also help you get ahead financially as you build your solo business.

      It’s possible to turn your finances around by creating a realistic household spending plan, aggressively cutting your expenses, and sticking to the guidelines you set. Using your money to create a secure financial future, instead of spending it on material possessions, can give you a feeling of freedom that expensive toys never deliver. But you have to decide what’s truly important to you. We’ll cover much more about managing your money in Part III.

Ditch Your Debt

      Another important financial safety net for many solopreneurs is to reduce what you owe. Having fewer debts can take the pressure off if your pay gets cut, your business income drops, or you lose your job. It can also be the key to living within your means if you tend to overspend.

      If your finances go in the red every month, or if you live paycheck to paycheck, you can’t get ahead and build wealth for the future. Knowing that you’re going backward financially or even just treading water can cause a lot of stress.

      For some people, owing any amount of money can be a source of anxiety—even if you’re meeting your expenses and diligently saving for the future. In some cases, additional income from a side business may be the answer to paying down debt or saving more. But if working a W-2 job and simultaneously building your business on the side isn’t sustainable, it’s time to reevaluate your debt load.

      If you’re using credit cards and loans to finance a lifestyle you can’t truly afford, consider the consequences. Having little or no discretionary income can hold you back from building the business and life you want in the future.

      One way to analyze and monitor your debt level is to calculate your debt-to-income (DTI) ratio, which is how much you’re paying for debt, such as minimum credit card payments, student loans, auto loans, and mortgages, compared with how much you earn:

      DTI Ratio = Debt Payments / Gross Income

      A healthy DTI ratio is less than 35 to 40 percent. For example, let’s say the total of your mortgage payment, car loan, student loan, and minimum credit card payment is $2,500 per month, or $30,000 per year. If you earn $80,000 a year, your DTI is $30,000